When evidence strips one back to their ideological core

It will be a relatively short blog today as I am off travelling again. Yes, I was home one day! Real GDP gaps, which measure the extent to which economies are producing below their potential (indicated by full employment of labour and existing capital resources), remain large across many of the large advanced economies. That means one thing – current output growth is not strong enough given the real resources available to these nations. It means another thing – that potential growth will start to fall as investments in productive capital and human capital falters as a result of the lack of demand for current output. Given current capacity (labour and capital), the utilisation of it depends on spending and spending alone. That means another thing. Policies that deliberately undermine the current demand for output will not help economies to exit this crisis. So the only debate worth having is how to stimulate spending and that leaves all the discussions about the need for fiscal austerity on the sidelines of irrelevance. At what point will the economists supporting austerity realise that?

Clive Crook’s Bloomberg Op Ed (September 19, 2012) – The Fed’s Best Rationale for QE3 – analyses why the US Federal Reserve is correct in pursuing what is now being called QE3. He noted:

The U.S. economy needs QE3 because it is suffering from a deficiency of demand and because the Fed’s policy interest rate is already at zero. It also is the right decision because the paralysis in Washington rules out the first choice under such conditions: further fiscal stimulus.

Nobody, as far as I know, is denying that with so many workers and other resources idle, the economy needs more demand. To oppose quantitative easing, you have to argue that it won’t have the required demand-inducing effect.

I will come back to QE3 in another blog next week. But today I am focusing on fiscal policy.

On September 16, 2012, Lawrence Summers provided an article for the Financial Times – Britain risks a lost decade unless it changes course – which made an emphatic case for renewed fiscal stimulus in the UK.

Summers is now playing this role in the public debate which sort of goes like this – please forget history and my role in it and instead focus on what I am saying now. In Summers’ case – history and today – are dissonant.

On history – here is a 2009 blog – Being shamed and disgraced is not enough – which documents to some extent the role that Summers played (with Rubin and Greenspan) in creating the financial crisis and its lingering malaise. His hands are very unclean and we know that underlying whatever he says is a flawed New Keynesian macroeconomic model.

But today (as in the current period) – Larry Summers sounds like the voice of reason.

In his FT Op Ed, he makes the obvious point – when does someone abandon their pre-held convictions and views in the face of evidence to the contrary:

… it is fair to ask economists a fundamental question: what could happen that would cause you to revise your views of how the economy operates and acknowledge that the model you had been using was flawed? As a vigorous advocate of fiscal expansion as an appropriate response to a major economic slump in an economy with zero or near-zero interest rates, I have for the past several years suggested that if the British economy – with its major attempts at fiscal consolidation – were to enjoy a rapid recovery, it would force me to substantially revise my views about fiscal policy and the macroeconomy.

I would note from a philosophy of science perspective we should not get lulled into the security of thinking in terms of falsifiability a la Popper. But I agree in general with the view that while evidence cannot prove anything or light up the way to truth, it can certainly tell us whether an idea we hold has any traction with what is going on (that is, as long as the idea has an evidential manifestation).

Upon election in 2010, the current British government claimed that fiscal austerity was the key to growth – because governments, like households, have to live within their means. They said that the budget deficits that had risen on the back of the automatic stabilisers as Britain struggled with the worst recession since the 1930s had to be repaid and this would require onerous future tax burdens, which would force the future generations to pay for the profligacy of the current.

They also argued that government borrowing (to “fund” the deficits) competed with the private sector for scarce available funds and thus drove up interest rates, which undermined private investment – the so-called “crowding out” hypothesis.

They also told us that because governments are not subject to market discipline, public use of scarce resources is wasteful. Finally, they asserted that deficits would be inflationary unless they were reined in quickly.

But they went further than this meagre rehearsal of the mainstream dogma – which, by the way, Lawrence Summers mostly agrees with if we are to judge his historical record.

The British government also claimed that quite apart from these alleged negative impacts, budget deficits are not required to achieve growth. They rejected the view that government deficits could stimulate production by increasing overall spending when households and firms were reluctant to spend.

In a bizarre reversal of logic, David Cameron and George Osborne displayed their neoliberal credentials and told the British people that the economy could achieve an “expansionary fiscal contraction” – despite all logic and evidence pointing to the absurdity of this notion.

They held fast that by cutting public spending, more private spending will occur.

To justify that inanity, they appealed to the notion that is deeply ingrained in mainstream macroeconomics but rarely fully understood – “Ricardian Equivalence”. The name is fancy but the idea is, in fact, simple – like most of mainstream economics. The substance is thin but the jargon is complex – which hides the lack of substance.

The idea is this: Consumers and firms are allegedly so terrified of higher future tax burdens (needed, the argument goes, to pay off those massive deficits) that they increase saving now to ensure they can meet their future tax obligations. So increased government spending is met by reductions in private spending-stalemate.

But, as the neoliberals argue, if governments announce austerity measures, private spending will increase because of the collective relief that future tax obligations will be lower and economic growth will return.

Please read my blog – How are the laboratory rats going? – for a detailed critique of this assertion.

The historical record shows that it has failed to accurately describe what happens when governments engage in fiscal austerity. Fiscal austerity was always going to worsen the crisis, because the notion is built on a series of lies.

Public deficits do not inevitably cause inflation, nor do they impose crippling debt burdens on our children and grandchildren. Deficits do not cause interest rates to rise, choking private spending. Governments cannot run out of money.

The empirical world is continually spitting out data that allows us to judge the veracity of these claims and counter-claims. Since the onset of the crisis, the neoliberal narrative has run into some inconvenient facts. Interest rates remain low. In most of the developed world, inflation is falling and where it is rising, it is due energy and food costs rising rather than excessive deficits.

But what about Ricardian Equivalence? Should we not be seeing private sector confidence and spending rising by now – especially in the UK which is now 3 budgets into austerity and in Ireland which has been hacking away in the name of Ricardo since early 2009?

The evidence that the British government’s theoretical model is wrong is compelling. The economy is now back in recession and consumer and investor confidence is low and private spending remains subdued.

Larry Summers agrees that the evidence produced over the last several years has not supported the British government’s approach:

Unfortunately for the British economy, nothing in the past several years compels me revise my views. British economic growth post-crisis has lagged substantially behind the US and the gap is growing. British gross domestic product has not yet returned to its pre-crisis level and is more than 10 per cent below what would have been forecast from the pre-crisis trend. The cumulative output loss from this British downturn in its first five years exceeds even that experienced during the 1930s. Forecasts continue to be revised downwards, with a decade or more of Japan-style stagnation emerging as a real risk.

So what should be done?

Larry Summers’ Plan for Britain is based on his current view that “Until and unless there is a substantial reversal on near-term fiscal consolidation, Britain’s short and long-run economic performance is likely to deteriorate”.

The British government’s view is that “aggressive fiscal consolidation” has to continue. They will not be changing direction any time soon.

In a long essay in the UK Guardian (September 19, 2012) – Cameron’s coalition: a government with ominous intent – we read that:

Dogma is the strength of Cameron’s determination to dismantle the state, while disarray is his confusion and incompetence in carrying it out. People assume political leaders know what they are doing, when in fact they are often deeply confused. Cameron, like all modern politicians, gets swept up by one day’s headlines. He is also in thrall to Tory beliefs that are often confused and contradictory. He has been a navigator without maps, usually oblivious and indifferent to the unintended consequences of his policies. In health, criminal justice and welfare the Cameron era has to be characterised by the 2012 catchphrase “omnishambles”. Yet if his programme has been less grand design than instinct, the urge to cut back the state was strong and has given the Tories identity and impetus. This has been and remains a government with ominous intent …

Cameron’s stiff-necked insistence on sticking with his cuts shows that despite the haplessness and chaos, his inner ideological core is steely. State shrinkage was and remains his government’s guiding light. Cameron’s cuts will permanently damage and diminish government and collective endeavour, and in that sense he may still leave the field a winner.

But back to the starting point – real GDP gaps.

Larry Summers knows full well that “the principal factor holding back the British economy over both the short and medium term is the lack of demand”.

Irrespective of the “important structural issues ranging from difficulties in promoting innovation to deficiencies in the system of worker training”, it remains clear that “it is lack of demand that is holding the economy back”.

The point is that the mainstream economists get side-tracked by an obsession with microeconomic efficiency. In my talk on September 7, 2012 to the European Commission I emphasised this point.

Please read my blog – European Commission – Jobs for Europe Conference – for a video of my presentation if interested in the full context.

In that talk, I noted a quote from the US macroeconomist – the late James Tobin. The quote I alluded to was:

Any economics student can expatiate on the inequities, distortions, and allocation of inefficiencies of controls or guideposts or tax rewards and penalties. But just consider the alternative. The microeconomic distortions of incomes policies would be trivial compared to the macroeconomic costs of prolonged underemployment of labor and capital. It takes a heap of Harberger triangles to fill an Okun Gap.

[Reference: Tobin, J. (1977) ‘How Dead is Keynes?’, Economic Inquiry, 15(4), 459-68].

Arnold Harberger was a University of Chicago economist/econometrician who coined the term “Hargberger Triangle” to denote the graphical area in a demand and supply graph that measures the deadweight loss arising from taxation. The triangle became an oft-used graphical device to portray microeconomic or so-called welfare losses in a variety of “markets” due to inefficiencies brought about by government regulation (such as minimum wages, welfare payments etc).

An Okun’s Gap (named after the US economist Arthur Okun) measures the loss in real output (income) arising from unemployment when an economy is operating below full employment because of demand constraints.

For aficionados, you might like to read this Letter to a Younger Generation which was written in 1998 by Arnold Harberger who is now 88 years old. He reflects on this quote.

Harberger said that:

Tobin was implicitly attributing as a social cost the entire gap between actual and potential GDP, and by innuendo criticising the approach of measuring costs solely in terms of the types of distortions usually considered in applied welfare economics. In effect, he was saying that the distortions approach misses the point, that it fails to capture the lion’s share of the real costs of a shortfall of output.

The simplest calculation reveals that the daily income losses alone of having that many people idle dwarf any reasonable estimate of microeconomic losses arising from the so-called “structural inefficiencies” or microeconomic rigidities (a favourite of the IMF) that have dominated public debate over the neo-liberal era.

It is well documented that sustained unemployment imposes significant economic, personal and social costs that include:

• loss of current output;
• social exclusion and the loss of freedom;
• skill loss;
• psychological harm, including increased suicide rate (which I will return to later);
• ill health and reduced life expectancy;
• loss of motivation;
• the undermining of human relations and family life;
• racial and gender inequality; and
• loss of social values and responsibility.

Many of these “costs” are difficult to quantify but clearly are substantial given qualitative evidence.

It is just plain madness to ignore these huge costs and then go about pursuing policies designed to reduce small costs (if they exist). A further problem is that in pursuing these micro costs the government almost always will increase the macroeconomic costs.

We also know that the losses encountered during a prolonged recession reverberate into tortured recoveries and that the damage that unemployment causes spans the generations.

Even before the crisis hit, these costs in most countries were huge as policy makers began using unemployment as a policy tool rather than a policy target as the obsession with inflation-targetting took hold.

Most people do not consider the irretrievable nature of these losses. Every day that unemployment remains above the full employment level (allowing for a small unemployment rate arising from frictions – people moving in-between jobs) the economy is foregoing billions in lost output and national income that is never recovered.

The magnitude of these losses and the fact that most commentators and policy makers prefer unemployment to direct job creation, shows the powerful hold that neo-liberal thinking has had on policy makers. How is it rational to tolerate these massive losses which span generations?

The extent these losses are generally withheld from society in general. That is, national statisticians do not try to estimate them and commentators avoid discussing them.

While the unemployed and their families are certainly aware of them, the remainder of the society are less aware. For example, we might notice rising crime rates in our neighbourhoods but do not associate it with unemployment. The narrative is always that individuals are to blame for these sort of outcomes.

Neo-liberalism has also changed the way we think about unemployment. In the past we understood clearly that it arose as a result of a shortage of jobs.

However, in recent decades, we have been conditioned by a relentless (lying) press and government statements to perceive unemployment as an individual problem. So the unemployed are type-cast as being lazy; having poor work attitudes; refusing to invest in appropriate skills; and subject to disincentives arising from misguided government welfare support, and all the rest of the arguments that mainstream uses to obfuscate the social problem.

The focus in the public debate is to “blame the victim” and suggest that most are unemployable and prefer to live on welfare, where that support is available.

Take Mitt Romney’s recent claims about the 47 per cent as a reflection of this malicious bias that political leaders perpetuate to justify pernicious policy regimes which undermine the opportunities available to the least advantaged.

The overwhelming evidence from the informed research literature is that almost all the unemployed (when surveyed) prefer to work and are willing to take work if offered.

The overwhelming evidence from studies in most countries suggests that the unemployed are highly motivated to find work and are victims of a shortage of jobs rather than personal/individual deficiencies.

The dominance of the neo-liberal ideology has led governments in most countries to have eschew the adoption of policies of direct job creation to reduce the rate of unemployment and to minimise these massive costs. Fiscal policy has became geared to the achievement of budget surpluses as some sort of token of prudent financial management.

Larry Summers – in his present mode – is fully aware of the massive dead-weight losses that persistent real GDP gaps bring – and why a focus on structural problems is misplaced in the current environment:

During the depression, John Maynard Keynes compared Britain’s economic woes to a “magneto” problem, referring to the fact that a car might have many infirmities but if its electrical system did not work the car would not go. If that was fixed, the car would run, even with other problems. So it is today.

Moreover, he is also aware of the so-called “hysteresis effects” such that “short-run increases in demand and output would have medium to long-term benefits”

Please read my blog – NAIRU mantra prevents good macroeconomic policy – for more discussion on this point.

My PhD was initially focused on hysteresis. The point of that work in the mid-1980s was that many structural imbalances are in fact cyclical in nature. Accordingly, a prolonged recession may create conditions in the labour market which mimic structural imbalance but which can be redressed through aggregate policy without fuelling inflation.

Structural constraints that emerge during a large recession can be wound back by strong fiscal policy stimulation. For example, recessions cause unemployment to rise and due to their prolonged nature the short-term joblessness becomes entrenched long-term unemployment. The unemployment rate behaves asymmetrically with respect to the business cycle which means that it jumps up quickly but takes a long time to fall again.

If GDP growth remains deficient then the idle labour queue will remain long and employers will use all sorts of screening devices to shuffle the workers in the queue. They increase hiring standards and engage in petty prejudice.

The long-term unemployed are also considered to be skill-deficient and firms are reluctant to offer training because they have so many workers to choose from.

But to understand what happens during a recession we need to consider the cyclical labour market adjustments that occur.

The hysteresis effect describes the interaction between the actual and equilibrium unemployment rates. The significance of hysteresis is that the unemployment rate associated with stable prices, at any point in time should not be conceived of as a rigid non-inflationary constraint on expansionary macro policy. The equilibrium rate itself can be reduced by policies, which reduce the actual unemployment rate.

The idea is that structural imbalance increases in a recession due to the cyclical labour market adjustments commonly observed in downturns, and decreases at higher levels of demand as the adjustments are reserved. Structural imbalance refers to the inability of the actual unemployed to present themselves as an effective excess supply.

The non-wage labour market adjustment that accompany a low-pressure economy, which could lead to hysteresis, are well documented. Training opportunities are provided with entry-level jobs and so the (average) skill of the labour force declines as vacancies fall. New entrants are denied relevant skills (and socialisation associated with stable work patterns) and redundant workers face skill obsolescence. Both groups need jobs in order to update and/or acquire relevant skills. Skill (experience) upgrading also occurs through mobility, which is restricted during a downturn.

An extensive literature links the concept of structural imbalance to wage and price inflation. It can be shown that a non-inflationary unemployment rate can be defined which is sensitive to the cycle. Given that inflation typically results from incompatible distributional claims on available income by firms and workers, unemployment can temporarily balance the conflicting demands of labour and capital by disciplining the aspirations of labour so that they are compatible with the profitability requirements of capital. This is the underlying reason why inflation targetting uses unemployment and a policy tool rather than as a policy target!

The long-run is thus never independent of the state of aggregate demand in the short-run. There is no invariant long-run state that is purely supply determined.

By stimulating output growth now, governments also help relieve longer-term constraints on growth – investment is encouraged and workers become more mobile.

The supply-side of the economy (potential) is influenced by the demand path taken. Hysteresis means that where you are today is a function of where you were yesterday and the day before that.

That is the point that leads Larry Summers to argue that:

A stronger economy means more capital investment and fewer cuts to corporate research and development. It means fewer people lose their connection to good jobs and become addicted to living without work. It means that more young people get first jobs and it means more businesses choose leaders oriented to expansion rather than cost-cutting. The most important structural programme for raising Britain’s potential output in the future is raising its output today.

He then rejects, in turn, the criticisms that the conservatives raise to counter the call for more fiscal stimulus.

1. Fiscal deficits will push up interest rates and public debt will become unsustainable – “This line of argument is profoundly flawed … the behaviour of financial markets suggests that economic weakness rather than profligacy is the main source of concern about future credit problems”.

2. Fiscal deficits have to be reined in with austerity measures – “the primary determinant of fiscal health in both the US and UK over the medium term will be the rate of growth”. Note that Modern Monetary Theory (MMT) would not use terms such as “fiscal health”. But a healthy fiscal position is defined only with reference to other major macroeconomic aggregates – full employment and price stability.

Conclusion

I also agree with his conclusion:

But when demand is needed for growth and the private sector is hanging back, the first priority must be for the public sector to stop exacerbating the contraction.

The accumulating evidence that austerity is damaging economies is stripping bare the claims of its proponents. Their ideological cores are being exposed like never before. All the smokescreens they have erected are being blown away by each new data release from one national statistical agency to another.

As we saw in the US with the Romney 47 per cent episode, they just lie as a tactic to deny what the evidence is telling everyone. They rely on collective illiteracy (about data etc) to maintain those lies.

Fortunately more and more people are becoming literate and have self-publishing platforms available to spread the alternative (blogs!).

Anyway, must rush now …

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My band – Pressure Drop – is playing in Melbourne on Friday and Saturday night.

Please check out the Gig Guide for details if you are interested.

That is enough for today!

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.